Home > Economics - General > Postdicting the meltdown

Postdicting the meltdown

September 26th, 2008

My column in yesterday’s Fin started with the observation “The pace of events in financial markets has been so rapid that any projection of events in the short term seems likely to be obsolete soon after it is printed.”

Ignoring my own advice, I wrote a piece yesterday for Crikey (over the fold) which included the prediction “The largest remaining savings & loan firm, Washington Mutual is unlikely to survive into next week, with the most likely outcome one involving a large scale default on its mortgage obligations.” By the time it appeared today, it was a postdiction.

The casualty list from the stunning events of the last few weeks on Wall Street is an impressive one. In this short space of time, the US Administration has effectively nationalised the main mortgage guarantors, Fannie Mae and Freddie Mac and the world’s largest insurance company, AIG. The massively profitable Wall Street investment banking industry has ceased to exist, with Lehmans bankrupt, Merrill Lynch sold and Goldman Sachs and Morgan Stanley seeking the safety of commercial bank status. The largest remaining savings & loan firm, Washington Mutual is unlikely to survive into next week, with the most likely outcome one involving a large scale default on its mortgage obligations.

The reputational damage is equally severe. The Bush Administration’s place as the worst in US history has been cemented, with a financial and economic disaster to match the Iraq catastrophe. Alan Greenspan, whose policies were responsible for the current mess, was still being treated as an elder statesman a few weeks ago, but his reputation is gone for good now. And Henry Paulson and Ben Bernanke look set to follow a similar path, as their $700 billion bailout plan is exposed as a massive example of rentseeking.

But there is much more to come. Assuming (a big assumption) that the Democrats hold their nerve, any bailout will require the public to be compensated with equity for any losses they incur on the purchase of mortgage-backed securities and similar toxic sludge. Since such losses are inevitable if the plan is to have any real benefits, the result will be a further extension of public ownership, to include a substantial number of the main commercial banks.

No doubt, when the crisis is over, these businesses will return to the private sector. But it’s hard to believe (as most financial commentators seem to be supposing) that things will rapidly return to something like the situation prevailing before the crisis began. For a start, large areas of financial activity (auction rate securities, CDOs, subprime mortgages, monoline bond insurance) have collapsed, and seem unlikely to re-emerge. The massive market in credit default swaps will almost certainly be shut down, and the even larger interest rate swap market is likely to be scaled back to levels where financial regulators can manage it. Reductions in executive pay have already been accepted as a bailout condition, and it will be a long time before they are reversed.

Going beyond these obvious casualties are the implications for economic and political theories. The efficient markets hypothesis, badly wounded by the dotcom fiasco a decade ago, must surely be discredited now. The most sophisticated financial markets the world has ever seen have produced a situation where securities depending ultimately on debts owed by people with neither income, assets nor any incentive to repay have been treated as if they were (quite literally) as good as gold.

More generally, the whole free-market ideology variously referred to as economic rationalism, neoliberalism or the Washington Consensus, is in serious trouble, at least as regards the role of financial markets. The central element of financial neoliberalism is the claim that modern global financial markets can do a much better job of managing risks than can national governments. Given the array of sophisticated financial products available to individuals and households, for example, it is assumed to be much better to rely on markets to provide retirement income than on public pension schemes.

The neoliberal view is the polar opposite of the Keynesian social democratic view, informed by the experience of the Great Depression. In this view, not only are governments the ultimate risk managers, but financial markets are part of the problem not part of the solution. While being necessary to mobilise private investment in a mixed economy, financial markets are seen, in the Keynesian view, as being inherently prone to destabilising speculation, which can induce large-scale macroeconomic failures.

The events of the last few weeks represent a striking failure of the neoliberal position. Although large-scale financial crises have been commonplace since the breakdown of the Bretton Woods system of financial controls in the 1970s, they have mostly taken place in the periphery of the global economy.

The debt crisis of the 1980s affected mostly the poorest developing countries. The crises of the 1990s hit middle-income countries in Asia, as well as Mexico, Argentina and Russia but had little impact on the main OECD countries. And, while the dotcom boom and bust can be seen in retrospect as a warning that the US was not immune to similar crises, the warning was ignored. Greenspan postponed any real adjustment with easy money and lower interest rates. Even the very modest responses that were made, such as the Sarbanes-Oxley act were soon being derided as an over-reaction.

That’s not possible this time. The losses are so great that they threaten to bankrupt most of the major remaining financial institutions in the US. And even if the original plan of a bailout without any compensating equity stake were politically feasible, it’s no longer economically sustainable. The foreigners on whom the US is depending to finance the bailout are already losing faith. A massive handout would raise a large risk of extending the panic from the financial sector to the US government as a whole.

So, there is no alternative to a drastic cutback in the size and power of the financial sector and to a return to reliance on government as the ultimate risk manager. The events of the past few weeks have been so rapid that people have had little time to absorb them, let alone adjust their world views. But, as time passes, it will become steadily more evident that the day of neoliberalism is done.

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  1. smiths
    September 26th, 2008 at 16:09 | #1

    great stuff john, however, there is a small details i have to correct

    sir alan greenspan, knighted for his services to rich anglo-saxons, would still be very much in favor with those whom he so splendidly served

  2. September 26th, 2008 at 16:32 | #2

    i wish it were true. but the character of government remains that of facilitator of economic piracy, the structures of political governance remain elitist and will find some way to allow the smarties to get their snouts back in the trough.

    the system can’t change until the law changes, and that requires a new constitution. that won’t happen while the rich and their servitors hold legitimate power. marx was right about this much: real change must come from the bottom up. mao was right, too: it won’t be a tea party.

    so we’ll stagger along, wondering why society must experience periodic convulsions, resource exhaustion, effluent pollution, and simple war, famine, disease, and being assured the system is fundamentally sound by academic bellwethers.

    politicians have been running western society for several hundred years now, and the results seem to me to be so unimpressive that i regard the emergence of alqaeda to be be perfectly natural.

    as i wouldn’t like to live in a fundamentalist society (i have), i hope that a guerrilla group espousing democracy pops up soon, with fife and drums, and a bare-bosom marianne. no guns- laughter is the tool to confront medievalist supporters of parliamentary oligarchy.

  3. observa
    September 26th, 2008 at 16:47 | #3

    More pointless snark deleted. For heavens sake, obby take a break from this stuff

  4. Joseph Clark
    September 26th, 2008 at 16:48 | #4

    John,
    I’m curious to know your proposal for the financial markets. What kind of regulator do you want? Which transactions should be allowed?

  5. Spiros
    September 26th, 2008 at 16:53 | #5

    “The efficient markets hypothesis, badly wounded by the dotcom fiasco a decade ago, must surely be discredited now.”

    In which case, where does this leave the idea that the most efficient way to cut back on carbon emissions is to create markets for them – not just a spot market, but the usual collection of derivatives as well?

    Maybe a plain old carbon tax is the way to go, after all.

  6. jquiggin
    September 26th, 2008 at 17:01 | #6

    #5 Certainly, I think we have to scale back expectations for the usefulness of derivatives markets. However, the case I’ve made for emissions trading doesn’t even mention benefits from this source, so it is unaffected by the possibility that derivative markets won’t emerge on a large scale. And this doesn’t say anything much about spot markets.

    http://johnquiggin.com/index.php/archives/2008/07/07/carbon-taxes-vs-emissions-trading/

  7. Patrick Caldon
    September 26th, 2008 at 17:05 | #7

    John,

    Further on #4, why do you think Sarbanes-Oxley turned out to be a paper tiger?

  8. Spiros
    September 26th, 2008 at 17:20 | #8

    Yes, what is to stop markets for toxic carbon derivatives emerging on a large scale?

    The key buyers and sellers of carbon credits will argue that it is reasonable that they be able to hedge their exposures. So we should allow very simple and transparent derivatives, like say a futures market.

    And maybe some simple options as well…

    But it’s a slippery slope. Before you know it, we’ve got the carbon equivalent of CDOs.

    Who is going to regulate all of his?

  9. September 26th, 2008 at 17:23 | #9

    John — this is really ignorant stuff.

    Fannie Mae & “redlining” legislation, fueled by interest rates from the Fed set at below the natural rate, generated a classic artificial book and inevitable bust as explained by Hayek — a systematic distortion of the market created by systematically misleading prices, and systematically perverse incentives. There is nothing surprising or unanticipated by a Hayekian “neoliberal”. In fact, they are the only ones who can explain what has happened.

    Also, it is just pure ignorance to equate the “efficient market hypothesis” of 1970s Chicago economists with “neo-liberalism”. The leading “neoliberal” of them all — Hayek — rejected such notions.

    Time to learn some facts about the American mortgage finanace regulatory regime — and some economics.

  10. jquiggin
    September 26th, 2008 at 17:27 | #10

    I’ll need a lot of post and a big thought before I can provide all the details on my planned reinvention of financial regulation :-) .

    But a couple of points are obvious, and not new with me

    (1) The current over-the-counter derivatives markets for CDS and interest rate swaps need to be replaced with exchanges where it’s possible to net out obligations
    (2) Positions in these markets need to be brought on to balance sheets and treated as capital at risk

    That would reduce the outstanding volume by a factor of at least 10 and probably a factor of 100 (that is, from $300 trillion nominal value and several trillion in obligations to perhaps $3 trillion and tens of billions, the latter figure being enough for governments to deal with if things go wrong.

  11. observa
    September 26th, 2008 at 17:41 | #11

    Pointless snark? The point is very poignant under the circumstances and needed answering John. Basically you say ‘neo-liberalism’(and that’s a very loose term) has failed and the evidence is all around us. Presumably that means Govt should step in and redress market failure thus-

    ‘The Federal Government has today taken steps to boost competition in the mortgage market.

    “The government will direct the Australian Office of Asset Management – the AOFM – to invest in triple-A rated mortgage-backed securities to boost competition,” Treasurer Wayne Swan told reporters in Canberra after trading on the stock exchange had closed.

    “Boosting competition is something the government has been emphatic about.

    “We need to have a competitive mortgage market so that people out there who are under financial pressure can get a fair go.

    “This is an important measure to introduce competition into the mortgage market over time.”‘

    I put it to you that so called ‘neo-liberalism’ really had an impossible task. OTOH it was being asked to only invest that ever increasing quantity of fiat money in AAA mortgages presumably and OTO actively compete ‘so that people out there who were under finacial pressure could get a fair go’. Now I’m being asked to believe that task can safely and largely be left to Govt. I say the fundamental problem was the moral hazard created by central bankers lack of oversight in the first place and this announcement by Govt is simply more of the same. An impossible task!

    Care to refute that this is simply frying pan and fire stuff if the moral hazard of fiat money creation continues? Indeed the very notion of competition is nonsensical here when Govt has a monopoly on money creation in the first instance.

  12. Ian Gould
    September 26th, 2008 at 18:29 | #12

    “politicians have been running western society for several hundred years now, and the results seem to me to be so unimpressive that i regard the emergence of alqaeda to be be perfectly natural.”

    Yes, oh for the good old days of the 15th and 16th centuries.

  13. Ian Gould
    September 26th, 2008 at 18:35 | #13

    It really is marvelous how some posters can take ANYTHING and interpret as support for their particular obsession whether it be the gold standard or citizen-initiated referenda.

    Im waiting for Jack Strocchi to announce that the solution to the current market turmoil is reduced immigration.

  14. September 26th, 2008 at 18:42 | #14

    Before attributing this to “neo-liberalism” we should have a careful look at the actual problems.

    One problem, as mentioned by Presto and many Austrian and free-market economists over the last 5-10 years, is that the fed seems to have set the interest rate too low for too long… leading to malinvestment.

    Another problem has been various regulations relating to home loans. Anti-discrimination legislation effectively meant that banks were forced to give loans when it wasn’t appropriate. Another weird piece of legislation means that an American home-owner can simply walk away from their home if it goes into negative equity. A close friend in banking thinks this may be a big explaination for why things are so bad in the US but relatively OK in Australia.

    Another problem was the implicit guarantee behind Freddie & Fannie… and perhaps also behind any financial institution that’s super-big. This undermines the need to appropriate assess risks.

    So far, none of these problems are problems with “neo-liberalism”.

    However, these aren’t the only things in play. Clearly, many market analysts have made bad decisions. Also, we do seem to be facing exactly what Keynes worried about, a liquidity problem with people hiding money under their mattresses.

    But these things aren’t market failures. They are parts of the market in a world with humans instead of robots. The appropriate market response to business failure is to allow the business to fail. The appropriate market response to falling liquidity is for the money-supplier (fed, RBA) to offer a temporary offsetting increase in liquidity.

    Far from showing a major problem in “neo-liberalism” (or efficient markets hypothesis, which isn’t really relevant here at all) this episode has shown (1) the dangers of a lax monetary policy and bad bank regulations; and (2) that everybody makes mistakes, but thankfully the market is here to correct them.

    The conclusions are harder to determine. How can we make sure the fed is more diligent at carefully controlling money supply? How can we prevent government introducing bank regulation that leads to inefficient capital allocation? How do we stop the moral hazard?

    One option would be free banking. If Terje is around, I’m sure he’ll mention a gold standard. :)

    Finally — I’ll add that we shouldn’t have this bail-out. It’s corporate welfare. And the remuneration for financial CEOs should be linked to the future performance of their company. In case of a failure, share-holders should be asking for a refund.

  15. chrisl
    September 26th, 2008 at 18:57 | #15

    Spiros makes a good point re carbon trading. It is basically trading in a air.Take some air with a trace amount of co2. Trade air. Send “polluters” broke. Make traders rich. Return air with, 1 part less per million co2.

  16. Ikonoclast
    September 26th, 2008 at 19:45 | #16

    All I can say to JQ’s article is “Hear! Hear! hear!” How good it is to have it proven, by real world events no less, that neoliberlaism is bankrupt not only morally, logically and ideologically but also, in fact, financially.

    These weeks are truly the weeks where all the prophecies of neoliberalism have failed and failed completely, utterly and disastrously; being fully, absolutely, comprehensively refuted by real world events ie. refuted empirically.

    Anyone who clings to neoliberalism now is truly walking down the street with no intellectual clothing whatsover.

    STRIKE ONE! Keynesianism, by and large, vindicated!

    STRIKE TWO! Now for climate change. At what point will the deniers who have remnants of logic be forced to accept as fact that the globe is warming anthropogencially? I’d suggest when the Arctic has no summer ice ie less than 5 years.

    STRIKE THREE! At what point will the Peak Energy deniers be forced to accept that Peak Energy threatens world civilization? I’ll give that less than 5 years.

    STRIKE FOUR! (Four stikes in this ‘game’.) At what point will Limit to Growth Deniers be forced to accept that population, infrastructure and industrial growth cannot continue indefinitely in this world, the world being a finite place. I’ll give this one 10 years. It will be terribly obvious by then.

    Ikonoclast right on all points! Not because he is clever but simply because he;

    (1) Listened to the scientists and economists who were experts in the various relevant fields.

    (2) Compared the science and the political economy to a number of personal logical deductions easily derivable by anyone with a high school Senior education, bit of life experience and some intelligent reading.

    There is no excuse for the citizenry to resile from their responsibility to think for themselves.

  17. observa
    September 26th, 2008 at 20:11 | #17

    I agree wholeheartedly with you John H up until the point where you say-
    “The appropriate market response to falling liquidity is for the money-supplier (fed, RBA) to offer a temporary offsetting increase in liquidity.”
    The problem here is that it was lax CB liquidity that caused the inevitable crisis of confidence in the first place and 2 wrongs don’t make a right now, something the market is beating us all over the head with right now. The mortal enemy of sound, prudent saving and investment is monetary induced inflation. When CBs kept the price of forgoing current consumption(ie returns for saving) artificially low, that was the signal for conspicuous borrowing. Hey, why not when you can pay it back with deflated currency, particularly with long term purchases like RE. Unfortunately with a greying demographic, they knew not what they were doing as general goods inflation remained relatively benign.(truly benign is zero or -1% or so in my book) Not so the baby boomers asset preferences as that ponzi scheme began in earnest, fuelled by Asian savers, often forced by Beijing mandarins and their machinations. That is our calamitous undoing now, because those planets aligned for so long and so deeply. The crash was inevitable, but it is really a crisis of trust now. Trust in our monetary managers who got it wrong and the finance industry that grew up to dispense all that initial largesse. In the end too many of us came to believe in something for nothing and now the grim reality of our folly must be firmly etched into the consciousness again. Money matters because ultimately it is our individual claim on real production over time. Bastardise it and you bastardise those claims and many of the claimants.

    So JohnH thinks we need more liquidity now so we can have more- ‘Here at Aussie we’ll save ya!’ The same Aussie who sold out to those nasty banks and pocketed his ponzi proceeds, when the funny money ran out. Now I’m supposed to believe that my Govt can pump up these ‘Aussies’ again to protect the value of my ponzi assets. My how the kids will be thrilled at saving inflated house prices eh Kevvy and Co? Or perhaps they’re just going to take over those AAA backed mortgages, which leaves what for the banks and shrinking NBFIs we may well ask? What will that do to the overall cost of less than AAA mortgages, assuming those public servants in Canberra don’t cost anything to double assess the AAAs, for the Govt’s grand investment plan. Where’s the sense, now the banks have got the message about the ponzi scheme and so have borrowers now. We need real returns for savers now to unwind the malinvestments and set us on the right investment path again, not more funny money propping up deflated egos.

  18. September 26th, 2008 at 20:20 | #18

    Ikon — you say that “neoliberalism” has failed, but you didn’t say how. Presumably you disagree with my assessment of the problems, but you didn’t say why.

    observa — it’s important to carefully identify the problem. A problem exists whenever broad money supply is out of kilter with “money demand”. That out-of-kilterness can exist in either direction… not just “too much money”, but also “too litle money”. The problem of recent history has been “too much money”, but a liquidity problem offers the exact opposite issue.

    I’m not suggesting loose monetary policy to try and “pump-prime” the economy out of recession. That indeed would be adding to the problem.

    But if you believe in keeping broad money supply stable (as I do), then you should believe in adding liquidity to the market now.

  19. smiths
    September 26th, 2008 at 20:41 | #19

    here, here, here, Ikonoclast, well spoken

  20. Ian Gould
    September 26th, 2008 at 22:39 | #20

    “Anti-discrimination legislation effectively meant that banks were forced to give loans when it wasn’t appropriate.”

    75% of mortgage lending and 90% of subprime lending was done by institutions not subject to such laws but I’m sure if you and your compatriots keep repeating that the CRA was a major cause of the crsis it’ll magically become true.

  21. Ubiquity
    September 26th, 2008 at 22:56 | #21

    Its not enough that our governments have complete control over the value of our money. Soon they will have complete control over our power resources. We will pay tax on power we use. The “Carbo Fed” created thanks to the AGW theory. As if the Fed Reserve experience wasn’t enough !

    One day I will walk into a public toilet. I will go to flush it using credits on my “carbo card” , but oops I am out of credits. Damn.

  22. observa
    September 26th, 2008 at 23:22 | #22

    Yes I understand that ideal liquidity(really value) John H, but it may be an insoluble problem in the short term in the sense that previous bad money (too much of it) is naturally driving down what current good there is. I fail to see how that can be rectified by Govt walking up to banks and offering to buy their AAA mortgages off them. Que? I must be from Barcelona. Why on earth would a bank want to flog off its best cash flow (you know the vast majority of those solid interest and capital repayments) for what? To find more dough to lend to slow and no payers in the current economic environment? And to top off that brilliant Govt brainfart, I’ll be expected to pay more taxes to have some more public servants (those intelligent central bank overseer types)to second guess what the banks already know. Give me strength!

    And they wonder why there’s a crisis of trust at present? You know, after being stroked that it’s largely the Yanks problem and our banks are well regulated and safe down here in Oz, yada, yada, it should be obvious to us all now they will need to unload $4bill of AAAs to your Govt for some ‘appropriate’ liquidity folks. Trust us we’re from the Govt and we’re here to help.

  23. Ian Gould
    September 27th, 2008 at 00:04 | #23

    “And they wonder why there’s a crisis of trust at present? You know, after being stroked that it’s largely the Yanks problem and our banks are well regulated and safe down here in Oz, yada, yada, it should be obvious to us all now they will need to unload $4bill of AAAs to your Govt for some ‘appropriate’ liquidity folks. Trust us we’re from the Govt and we’re here to help.”

    So Observa, you’re predicting a financial crisis here on par with the US?

  24. Ian Gould
    September 27th, 2008 at 00:07 | #24

    “And to top off that brilliant Govt brainfart, I’ll be expected to pay more taxes to have some more public servants (those intelligent central bank overseer types)to second guess what the banks already know. Give me strength!”

    You know those surpluses we’ve been running?

    Guess where this money is coming from?

  25. observa
    September 27th, 2008 at 01:29 | #25

    “So Observa, you’re predicting a financial crisis here on par with the US?”

    Well I must admit I wasn’t until the Govt dropped that bunker buster on us. Generally speaking we’re better positioned than the US to ride this out, but now we must have serious doubts about that with fiat money beginning to collapse globally. That will have real demand consequences and we’re a much traded economy. As well our house prices are some of the highest by world standards and that could change rapidly with rising unemployment. There’s an awful lot of boomers geared up on housing at present and what shock would it take to make them sub-prime suddenly? I note the Comm bank stated it couldn’t guarantee to pass on any future Reserve interest cut in the current environment too. Remember we’ve just had a 20% fall in our dollar and what that means for foreign denominated loans and we’ve had a long history of current account deficits to fund. This is all getting very ugly very quickly.

  26. observa
    September 27th, 2008 at 02:01 | #26

    Here’s a pretty succinct precis of the options for providing some ‘appropriate’ liquidity
    http://www.atimes.com/atimes/Global_Economy/JI27Dj03.html
    Note the time problems in assessing ‘appropriate’ liquidity here and also ask yourself where does buying good assets from our banks fit with any of those options? This is not a liquidity crisis. It’s a massive demographic solvency crisis upon us right now, because there was never any chance an aging demographic could sell out and retire on the proceeds of their past so called ‘investments’. It was all just old fools gold. A dwindling youth cohort could never pay the real price of that tectonic shift in economic resources and asset prices are about to reflect that obvious reality now.

  27. Ian Gould
    September 27th, 2008 at 02:05 | #27

    “…with fiat money beginning to collapse globally.”

    So, you’re predicting we’ll all be back on the gold standard?

  28. Bingo Bango Boingo
    September 27th, 2008 at 02:06 | #28

    jquiggin, the US financial markets are have tanked, whereas Australia’s haven’t (except by way of global contagion). You say the US approach is neoliberalism, which has failed. So my question is this: are Australia’s financial markets neoliberal or social democratic?

    BBB

  29. Ikonoclast
    September 27th, 2008 at 08:01 | #29

    In answer to Temujin at #14.

    I think we may be in danger arguing a little past each other rather than directly at each other’s points. I used the term “neoliberalism�. You preferred the phrase “efficient markets hypothesis� and went on to say “which isn’t really relevant here at all�. To me, this indicates I was talking Political Economy and you were talking Economics. There is no problem in that. Each of is entitled to come to the subject in our own way.

    The Wikipedia defines neoliberalism as follows.
    ‘Originally coined by its critics and opponents, “neoliberalism” is a label referring to the recent re-emergence of economic liberalism among political and economic scholars and policy-makers. Its supporters and proponents are influenced by neoclassical theories of economics and libertarian political philosophies and usually describe themselves simply as “economic liberals”.’

    I will admit a problem of categorisation always arises when one uses a term for one’s opponents when those opponents do not accept that term. I was using “neoliberalism” in the political-economic sense in which the position embraces policies of minimal government and more extreme free market economics (laissez-faire capitalism) combined with vigorous anti-unionism and a concerted program to dismantle the welfare state. “Thatcherismâ€? and the Omega Project prescriptions coming out London’s Adam Smith Institute were perhaps the apotheosis of this approach though George Bush’s administration has done a fair copy of the program.

    I think you were talking more about “economic liberalism� and the “efficient market� itself. I would simply argue that in Political Economy, i.e. in society, we can never separate politics from economics. Any package of economic settings is imposed by political process. Minimalist government may be defined as government limited to the Fisc, Treasury, Courts, Police and Military. Under this view, welfare, public education, communications, power and infrastructure utilities etc. are not seen as proper functions for the state. The ostensible purpose of minimal government is to basically guarantee contract law and maintain the state’s monopoly on violence (police and military). The state’s monopoly on violence is necessary to maintain the rule of law because otherwise anarchy would prevail. I have no problem with the state possessing these functions (with proper checks and balances) but I do have a problem with the state being limited to only these functions.

    Under neoliberalism or economic liberalism, one class (the rich or rentier class essentially) wanted to limit the state to these functions ostensibly out of a concern for the values of liberty and freedom but in reality because such a set up vastly favours their own class. When political power is thus limited (with democratic elections only ever producing minimalist government) then naked economic power comes to the fore and the rich basically get almost everything they want.
    The Wikipedia also notes, “Economic liberalism last exerted significant influence during the 1970s and early 1980s, in particular during and after the 1970s stagflation crisis and the wider effects of the 1970s to early 1980s Latin American debt crisis.[1] After a period of relative prosperity during the mid to late 1980s, renewed interest in economic liberalism began following the end of the Soviet Union in 1991. By the end of the 1990s, it had become an established trend.�

    Seeing economic liberalism and neoliberalism as a combined political-economic program and seeing it as the program which held all the reins in the Anglophone countries since 1990, I can judge that the current crisis as being what you get from such a program. The proof is in the pudding.

    Your specific arguments in some cases come close to my position. The Fed may have set interest rates too low and this may have been one of the causes of mal-investment. Other causes do include the moral hazard issue of implicit guarantees for certain institutions. I agree that a too ready availability of credit, particularly for consumer spending can and does cause inflation, particularly asset inflation and ‘bubbles’.

    ‘Market failure’ is a funny beast. If individual companies fail that is usually a sign of market success. The market is working to clear out inefficiency. If vast slabs of the market are failing, dozens of big banks and financial institutions failing, knocking on or potentially knocking on to the productive real economy where companies also begin failing and the whole market begins seizing up then this is a market failure as macroeconomic failure. Going back to what I said earlier (namely that it is always a matter of Political Economy and not merely politics or economics) this market failure contains a government failure too. On this point we would agree. However, the combined danger of government-market failure cannot be solved by giving the reins entirely over to the market. Just as giving over the reins entirely to government (the command economy) does not work either. This failure is a failure (and a spectacular one) of neoliberalism as a political-economic program.

    It is the death knell of neoliberalism just as it is the end of the “Project for the American Century�. It didn’t even last seven years. Overall, the USA’s dominance as the greatest power and one fully involved in world affairs lasted about a century or perhaps only 90 years. That is from about 1908 or 1918 to 2008. As I said in another post, this is now a very dangerous time as the USA’s massive military power will soon be badly out of balance with its waning economic power. We can expect the USA to begin acting even more aggressively and irrationally than it has been doing for the last 8 years. That is a very scary thought.

  30. observa
    September 27th, 2008 at 08:44 | #30

    “So, you’re predicting we’ll all be back on the gold standard?”
    Truth is I don’t know Ian and neither does anyone else but something really big is going down and it’s only just beginning to dawn on them-
    http://www.news.com.au/adelaidenow/story/0,22606,24408632-2682,00.html?from=public_rss
    It’s only just dawned on me that this is probably the massive demographic solvency crisis that was always hanging over our heads. There was no way a shrinking young cohort could be loaded up with the levels of taxation, HECS debts and inflated asset priced mortgages required to sustain its dependent parents’ generation in the manner to which they presumed they were entitled. That is what’s happening now. Those baby boomer expectations are being rapidly unwound and as they are it has obvious consequences for the very value of fiat money. I suspect that enormous strain will threaten the very medium of exchange now and inevitably gold is the last sanctuary. This is big, really really big and we are all in uncharted waters now.

  31. Ikonoclast
    September 27th, 2008 at 12:38 | #31

    Sorry, I have to laugh (but not unkindly) at those who want to go back to the “gold standard”. And I am not sure that Observa is necessarily advocating that. But some visitors here do seem to advocate that.

    There is nothing intrinsically magical or special or fundamental about gold that renders it more worthwhile as a money standard than anything else. The notion that you can only make “true money” out of gold or backed by gold is specious specie-ism; the specious theory of specie backed money. (I could not resist that play on words.)

    Specie backed currencies have given way to Fiat Currencies for good reasons. ‘The terms fiat currency and fiat money relate to types of currency or money whose usefulness results, not from any intrinsic value or guarantee that it can be converted into gold or another currency, but instead from a government’s order (fiat) that it must be accepted as a means of payment.’ – Wikipedia.

    Money exists to represent exchange values in an agreed accounting unit which is portable (think paper money) and now tele-communicatable (think data representing money. It is the business of the government to regulate the money supply. I am no expert on this and I haven’t read Keynes or subsequent theorists.

    But where there is a severe problem with the Fiat currency itself I would say the fault lies with the regulation of the money supply ie. the rate of creation of money by fiat relative to the economy’s need for money as a means of exchange to represent real values and real rates of exchange (trade) in the economy.

    So the problem in this case lies not with Fiat currency per se but the government’s poor regulation of it. Bad government regulation of the fiat money supply is no doubt not the only problem that impinges on fiat currencies but if that regulation is bad enough it will cuase a major problem.

    I don’t see how a gold standard could ever work now. There aint enough gold in them thar hills any more to back all the currencies and all the real values in the modern world economy. So any gold standard would be a kind of attenuated fiction now; not just a fiction but an attenuated fiction! :)

  32. Ikonoclast
    September 27th, 2008 at 12:44 | #32

    Oh, by the way, I don’t think gold is the last sanctuary. You can’t eat gold any more than you can eat paper money. I think hunter-gathering skills and a sufficient tract of land to exercise them on are the last sanctuary. By which measure, I seriously doubt there are any sanctuaries left.

  33. Ian Gould
    September 27th, 2008 at 12:50 | #33

    “I seriously doubt there are any sanctuaries left.”

    Speak for yourself. I’m a farm boy and have a pretty decent-sized back-yard. Just finished planting out some strawberries.

    I’d probably need to get some more chooks though.

  34. September 27th, 2008 at 13:04 | #34

    Ian Gould says:

    “75% of mortgage lending and 90% of subprime lending was done by institutions not subject to such laws but I’m sure if you and your compatriots keep repeating that the CRA was a major cause of the crsis it’ll magically become true.”

    Where did you get that figure from, Ian?

    Libertarians are certainly hammering the point that affirmative action lending is one of the major causes of the current US crisis.

  35. Ian Gould
    September 27th, 2008 at 13:41 | #35

    “As Robert Gordon shows, however, this is crap. First, there’s the timing. CRA came in 1977. The crisis came in 2007. Indeed, by 2004, the Bush administration had weakened the CRA — and after that (though not, presumably, because of it), bubble lending really took off. Further, CRA only governs a certain class of federally insured banks. Problem is, half of the subprime loans came from mortgage companies with no CRA involvement at all. Another 25%-30% came from companies with very little CRA exposure. For those who left their abacus at home, that’s 80% of the loans which were fully or largely outside CRA jurisdiction. More than that, the non-CRA mortgage firms made subprime loans at twice the rate of CRA-covered firms.”
    http://www.prospect.org/csnc/blogs/ezraklein_archive?month=04&year=2008&base_name=liberals_and_the_shtpile

    “Before I turn to potential interventions, I want to make one final point. There has been a tendency to conflate the current problems in the subprime market with CRA-motivated lending, or with lending to low-income families in general. I believe it is very important to make a distinction between the two. Most of the loans made by depository institutions examined under the CRA have not been higher-priced loans,16 and studies have shown that the CRA has increased the volume of responsible lending to low- and moderate-income households.17 We should not view the current foreclosure trends as justification to abandon the goal of expanding access to credit among low-income households, since access to credit, and the subsequent ability to buy a home, remains one of the most important mechanisms we have to help low-income families build wealth over the long term.”
    http://www.frbsf.org/news/speeches/2008/0331.html

    This is yet another case where libertarians are essentially buying into arguments which boil into “Decent white folk just can’t ahead because them Jew Lib’ruls in Washington be takin’ their hard-earned tax dollars an’ givin’ it to lazy no-account blacks.”

    Now if these arguments were actually presented in those terms the overwhelming majority of libertarians would reject them out of han but dress them up as “big government interfering in the free market” and they’ll happily swallow them.

  36. Salient Green
    September 27th, 2008 at 16:23 | #36

    Has anything been done to address the problem from the ground up?
    Why are there so many American households in financial crisis?
    How much would it cost to ensure these people have jobs, or that those jobs provide adequate pay, or that financial counselling is widely available, or that home loans must be paid before an employee recieves the pay packet? $700b?

  37. September 27th, 2008 at 18:23 | #37

    Ikon — if you agree the current problems are caused primarily by mistakes from the federal reserve and government, then it doesn’t make sense to declare this the death of neo-liberalism.

    Ian — I didn’t say the CRA was the major cause of anything. It was one cause among many. I did mention 5 or 6 problems in my first comment.

    For those who think this is a failure of the market, can you explain exactly the mechanism by which the current financial problems have come about?

  38. Ian Gould
    September 27th, 2008 at 19:11 | #38

    “For those who think this is a failure of the market, can you explain exactly the mechanism by which the current financial problems have come about?”

    People in the private sector paid too much for assets, including US Treasury bonds.

    That’s how essentially every financial crisis has occurred since at least Tulipmania and the South Sea Bubble.

    It is, as I’ve noted before, part of the cost we pay for the greater freedom of choice and the higher living standards capitalism can deliver.

    People who claim to support capitalism would use their time better admitting that and putting the case far capitalism rather than engaging in pointless scapegoating and insisting that the markets are good and therefore can never ever produce anything but good.

  39. Ian Gould
    September 27th, 2008 at 20:03 | #39

    I wish we had a Weekend Reflections thread, but seeing as the US economic mess seems to have taken over the blog and seeing as the various threads on it seem to have pretty much bled together, I might as well throw out a couple of thoughts here:

    1. Of the $700 billion proposed to be used to bail-out US institutions how much will end up going to federally-insured banks. The Federal Deposit Insurance Corporation seems to be rapidly running out of funds and may need to be bailed out itself to protect individual bank depositors.

    If it turns out that in the absence of a bail-out the US government would ultimately ende up paying otu a similar amount to depositors of failed institutions then the debate becomes somewhat academic doesn’t it?

    Secondly, is anyone else as appalled as I am by the astonishingly hypocritical behaviour of the US congressional Republicans?

    Knowing that the bail-out will be unpopular, they’re adopting a deliberately obstructionist approach and are trying to posture as enemies of “The Washington Establishment”.

    I’ve seen a lot of really cynical behaviour by politicians over the years but this is probably the worst.

  40. September 27th, 2008 at 23:40 | #40

    Would this be a fair way to para-phrase what you see as the problem: “market players have made bad decisions”.

    Because that one of the things I said in my first post.

    I’m glad you agree. Perhaps you will also agree that these mistakes are at their base caused by an incorrect assessment of risk.

    Mistakes by businesses do indeed have costs. But business mistakes do not constitute a failure of capitalism or a market failure.

    Anyway, it seems that we agree that people made investment and busines mistakes. Our difference is that I also think moral hazard, lax monetary policy and bad regulation also had a role in the current problems. Without those added causes, businesses will still make mistakes… but the market will correct them quicker and the problems will be smaller.

  41. September 28th, 2008 at 20:10 | #41

    “Our difference is that I also think moral hazard, lax monetary policy and bad regulation also had a role in the current problems.”

    The moral hazard argument is overstated because the major motivating factors for the primary decision makers in big companies (senior execs etc.) is maintaining and enhancing reputations and future earning capacity. If a big company goes bust the reputations and future employment prospects of the senior execs are effectively destroyed; the fact that there is a reasonable expectation that the company they sent to the wall will be the recipient of a Government bailout is irrelevant.

    The point about lax monetary policy sounds like Monday morning quarterback banter. As far as I can tell there was nothing approaching a consensus among classical liberal scholars on the perils of lax monetary policy before the current crisis. Where is the evidence of such an outcry?

    If I understand your point on bad regulation correctly, Ian seems to debunk it at #35.

  42. September 29th, 2008 at 01:20 | #42

    Mel — there were plenty of bad regulations. Ian only mentions one, and then admits that it still is a factor for 1/4 of loans. So it clearly was a factor. Another dodgy regulation was allowing home-owners to walk away from their home as soon as it has negative net equity. That’s not how things work in Australia.

    While plenty of neo-classical economists felt comfortable with recent fed monetary policy, nearly all Austrian economists have been complaining about it for a long time. The same people have also been complaining about lax monetary policy in Australia. I agreed with them about America but disagreed with them concerning Australia. I’m sticking with that assessment.

    Incidently, the reason for my relatively optimistic view in Australia is that I think the majority of house-price increases in Australia have been real increases in asset value, not a bubble. But that’s a different story.

    I accept there may be an agency problem at play in banks (as with many businesses), and this may decrease the size of the moral hazard problem (though it could also work the other way, as bankers would prefer to keep their job rather than maximise profits). Either way, I don’t accept that it could ever entirely remove the moral hazard problem. I know of few economists who think that moral hazard is insignificant. None actually.

  43. stuart
    September 30th, 2008 at 08:39 | #43

    One thing that doesnt seem to have been mentioned here (unless I’ve missed it) is the role of resetting mortgages in the crisis. The low honeymoon rates allowed for the inflation of US house prices over the last few years and the growth of the sub-prime sector which spilled over into the wider financial markets due through packaging them as CDO’s. Now house prices have fell as the situation unravels effecting other mortgages.

    The problem is a problem of regulation which allowed a sort of large scale ponzi scheme to develop. If loans werent allows to reset I really dont think that we’d be in this situation, as subprime borrowers wouldnt have been able to afford the initial interest rates stopping this process well before it reach the levels it did.

    The failure is of regulation and the assumption that market participants are rational. I think that on the whole this will lead to increased regulation of the financial sector rather than the wide scale collapse of neoliberalism. (although hopefully a fair bit of neoliberal doctrine takes a hit).

  44. Chris Warren
    September 30th, 2008 at 08:57 | #44

    Laughing and Crying at the Same Time

    In June the Sunday Edition of New York Times published an analysis of growth in US household debt.

    The trends displayed should not allow any economist to pretend they did not know the bust was coming.

    Debt as a proportion of household incomes has been increasing since 1900.

    The contradictions of capitalism have been papered over by continuous new forms of debt from early ‘hire purchase’ to ‘automobile loans, ‘housing loans’, then credit cards, then huge amounts of tuition loans.

    Now capo banks, who will kick workers out of their homes for the smallest credit default, want the government to keep them in their wealth for the biggest credit default.

    What economic theory covers this? What social justice makes sense here?

    I well remember when the Bankcard was proposed in early seventies. Opponents of Bankcard predicted dire consequences – I should go back to the pages of the now defunct “National Times” and check my recollection.

    I think we should blame the lazy career economists in the Universities – at least I do. They ignored fundamental underlying trends. The key trend is the decade by decade build up of per capita (or per household) debt.

    You cannot sell an item for more than was spent to produce it.

    Chris Warren

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